China credit ‘gambling’ via trust, bond lending

Debates aren’t slowing race to finance local government projects

By

ZhangZheyu

YangLi

BEIJING (Caixin Online) — Default risks seem remote among local government financing platforms that have raised trillions of yuan since last year via trusts, bank-sponsored wealth management products, securities and bonds — and plan to borrow a lot more.

Most borrowers and lenders converging inside this unconventional credit circle, which has widened dramatically since 2011 in the face of bank loan limits imposed by the central government, are wearing a happy face.

Borrowers include government officials getting the capital they need for GDP-boosting infrastructure projects. Investors include wealthy individuals, brokers and other investors enjoying decent returns. Banks, too, are benefiting as middlemen.

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Since local governments guarantee these lines of credit, an unspoken assumption is that higher levels of government — even the central government in Beijing — stands ready to step in and rescue any financing platform that might teeter toward default.

But some financial experts say these nothing-can-go-wrong assumptions, although popular, may be wrong. It’s also been argued that anyone looking closely at non-bank institutional lending will find dangerous cracks in the system.

Some experts say if the non-bank credit system collapses, the impact on China would rival the fallout from the subprime mortgage crisis four years ago in the United States, which shattered borrowers and financiers.

Trouble could be triggered by an extended slowdown for economic growth in China. This year’s gross domestic product expansion rate is expected to dip below 8% for the first time since 2004, and could slow further next year.

Bank of China Chairman Xiao Gang, writing recently in the state-run China Daily newspaper, said wealth management products are raising liquidity risks in financial markets. He’s particularly concerned about products that mature in less than a year but put money into long-term infrastructure projects linked to local governments.

Economic growth is needed to keep the ball rolling and defaults at bay, particularly since the credit system’s institutional oversight and government supervision are relatively thin compared to Beijing’s regulation of banks, said Liu.

“The game can continue because every party involved is unqualified” for standard, regulated bank credit, said Liu Yuhui, chief economist at Huatai Securities. “Both investors and fund-raisers lack self-regulation.

“Everyone is gambling.”

Risk or no risk?

Some 5.5 trillion yuan ($879 billion) was raised through trust funds over the past year, according to the China Trustee Association. About 22% of that money was earmarked for infrastructure projects.

So far, the default rate for this enormous and growing credit pool managed by trusts — the nation’s third-largest lending network, behind only banks and insurance financing — has been zero.

Urban bond sellers and buyers have been busy as well. A combined 471 billion yuan
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was raised through 401 bond projects between January and September, according to the market data firm Wind Info, compared to about 425 billion yuan raised during the whole year of 2011. Most of the money went toward roads, bridges and other urban construction projects.

Behind a significant percentage of this financing through trusts and bonds are wealth management products arranged and marketed by banks. Some products also put client money into securities. Clients can include brokers and financial institutions.

Because banks are not required to include wealth product data on their government-regulated balance sheets, these transactions have been largely ignored by watchdog agencies.

Regulators sensing the possibility of local government platform defaults ordered a halt to all new urban investment bond offers in July 2011. But just two months later, the regulator’s light turned green again and bond issuers were back in business.

The central government’s National Development and Reform Commission later endorsed bond financing by streamlining the bond application procedure. That move was followed by the bond boom that continues today.

One bond investor said this kind of deep government support has helped settle market fears about bond default risks.

The zero-default record is actually a sign of the bond market’s immaturity and fails to reflect true market conditions, said Wu Xiaoling, deputy director of the Financial and Economic Affairs Committee at the National People’s Congress.

Fraud suspicions have been voiced, too. A source at a major bank said that many recently “issued urban investment bonds are actually designed to pay debts for last year’s projects under the name of a new, fake project.”

A central bank-linked bond market supervisor called the National Association of Financial Market Institutional Investors (NAFMII) has even raised questions about the validity of bond ratings issued by credit rating agencies.

An NAFMII report said the agencies might have jumped the gun by issuing strong ratings early this year for bonds tied to infrastructure projects, building materials, transportation, real estate and energy. Those sectors have weakened more recently.

A fixed-income specialist at fund manager Harvest Fund said local government financing platforms overall are weighed down by “low quality” asset issues.

Bond program promoters argue that not a single bond issue has ended in default, although some got close and had to be bailed out by governments.

And investors are more than satisfied because bonds backed by local government assets — even those called “low quality” — have been yielding returns as high as 8%.

Many investors have accepted risk in exchange for high yields. And yet many say there’s really no risk involved, since the bonds have such strong government support.

“If a bond project has been approved by the NDRC,” said the Harvest Fund source, “the credit is backed by a government, whether at the provincial or county level. There is no risk for a single urban investment bond.”

One industry source said big-city government officials have warmed to bond fund-raising to the point where trust funds have been teaming up with lower level governments.

Yet, as bond fever spreads, some warn of shoddy fund-raisers backed by counties, villages and other small government branches.

A trust industry insider said many local governments with infrastructure projects are using land plots — sometimes vacant or in the process of being cleared — to collateralize debt. Often, the only verification of the land’s financial value is a letter from local officials.

“Even some villages are issuing trust products without any collateral after making up a story in order to raise funds,” said a source at Zhonghai Trust Co.

“If you only look at the projects and collateral, it’s clear there’s no way that the debts can be repaid,” the source said. “But nobody worries. They think a higher level of government will repay them. Everybody is betting on policy support.”

Bank ties

Most financial support for urban bonds has for the past two years has originated with bank-marketed wealth management products, said a source at Essence Securities.

Liu said up to 30 trillion yuan of the 66 trillion yuan in credit extended to all formal borrowers in China — a nation with a financial sector value assessed at about 125 trillion yuan — lies outside the banking system and has links to trusts, bonds and securities.

One securities trader said about half of all urban bonds issued on the secondary market were bought by banks with money from wealth management clients.

It’s an attractive business for the banks. Under China’s accounting rules, banks that run wealth management businesses don’t have to report all of this financial activity on their balance sheets. As a result, none of these moves are required to be reported under the bank regulator’s capital requirements for risk control.

Each of the Big Four state-owned banks handles an average 2 trillion yuan in off-balance sheet business every year, said a source from a major state-owned bank and most of that amount is tied to wealth management products. At the end of 2011, the outstanding value of all banks wealth management products in China has exceeded 4 trillion yuan.

And since wealth management products can yield less than 5%, while bond yield are as high as 8%, banks can pocket a healthy profit by working with product investors and local government borrowers.

A source at China Construction Bank
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one of the Big Four, admitted to potential risks tied to off-balance sheet business due to a lack of supervision and monitoring.

“The operations are not transparent,” the source said. And no one knows “how a loss should be shared by a bank and its customers.”

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